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One Stock to Buy Today?

Here's one stock we watched for too long.

According to data from TowerGroup, more than half of all U.S. investors make fewer than five trades per year. At the opposite end of the spectrum, just 0.3% identify themselves as day traders who make more than three trades in a day.

You've probably heard that trading is hazardous to your wealth, and you follow the Foolish principle of buy-and-hold investing set forth by Buffett, Lynch, et al. Good for you -- you're sticking to your guns, keeping taxes and commissions low, and trying to beat the market.

But ...When you're buying stocks infrequently, with the intent to hold them for extended periods of time, you probably sweat the buy-and-sell decision in a big way.

That's why we can't sufficiently emphasize the importance of keeping a watch list. Every investor needs a watch list -- and not just a few tickers scribbled on an envelope. We're talking about an unwieldy, expansive, and possibly color-coded endeavor.

Make every purchase countAt our Motley Fool Hidden Gems small-cap service, we add three companies to our watch list each month, in addition to making two formal recommendations. For the companies that go on the watch list, we either want a better price, or we want to see some sort of change in the business.

From there, a company may become a recommendation if the business improves, or if it sees a sudden and substantial drop in share price.

Enough introduction
Hornbeck Offshore Services went on my (Tim's) list in May 2006 after I listened to a presentation by Todd Hornbeck, the company's CEO, in New Orleans.

Here was a company making money hand over fist. As the operator of the most technologically advanced fleet of offshore supply vessels (OSVs) for larger energy companies, the firm possessed an important competitive advantage and was well-positioned to benefit from a long-term rise in energy prices. Finally, the CEO owned nearly 2% of shares and had his name on the door.

The stock only made it to the watch list, though, because we were worried about price.

A bit more backgroundHornbeck was then trading for approximately 20 times earnings, and it had more than tripled following its 2004 IPO. Even without crunching the numbers, the stock had gotten ahead of itself.

After all, energy is a cyclical industry, and 2006 was a boom year. What's more, Hornbeck was seeing even greater demand for its ships in the Gulf of Mexico because of damage wrought by Hurricane Katrina. The stock was priced as though this operating environment would continue indefinitely.

It didn'tFast-forward to Jan. 11, 2007. Hornbeck stock dropped 22% in a day after the company substantially lowered fourth-quarter guidance and announced that it could drop its 2007 guidance by as much as 20%.

Of course, now our interest was piqued. Hornbeck came off of the watch list and onto the whiteboard for more research.

But we didn't like what we found.

Operating OSVs is an extremely capital-intensive business. As the old saying goes, "The happiest days of a boat owner's life are the day they buy the boat and the day they sell it." And while Hornbeck was a very profitable company, it did not spin out a lot of free cash flow. With dayrates dropping, insurance and maintenance costs rising, and some volatility in the energy sector, it wasn't clear that Hornbeck:

Wouldn't fall any further; and

Would see sufficient returns to send the stock back up.

That, however, doesn't mean it's a "sell," either. The stock has more than recovered its January loss amid the current energy boom -- it's up 35% since the beginning of 2007 -- and remains reasonably priced on P/E and EV/EBITDA bases. We've also read several analyst reports calling it a buy.

Enough about HornbeckThere are several lessons here that can make us all better investors:

This last point is a particularly important one for investors to note. Consider, for example, the charts of Rite Aid (NYSE: RAD), Cypress Semiconductor (NYSE: CY), and Dillard's (NYSE: DDS). Like Hornbeck, these stocks can see volatility partly because they spend much of their operating cash on capital expenditures. In other words, they don't have a lot of room for error.

Contrast those companies with long-haul achievers such as Quest Diagnostics (NYSE: DGX), Polycom (Nasdaq: PLCM), and Nucor (NYSE: NUE). Partly because these companies spend less than 35% of their operating cash on capital expenditures, they can accumulate safety nets of cash and offer investors a somewhat smoother ride.

Will you be ready?At Hidden Gems, we scour the markets for great small companies that are generating lots of free cash. With thousands of small caps to research, we keep our watch list exhaustive and revisit it frequently. In fact, seven of our current recommendations -- recommendations that are beating the market at large by more than 19 percentage points since inception -- came from our watch list. You can see what we're recommending today, as well as our top five small-cap ideas, with a no-obligation 30-day free trial.

This article was originally published Jan. 30, 2007. It has been updated.

Neither Tim Hanson nor Brian Richards owns shares of any company mentioned. Quest Diagnostics is a Motley Fool Inside Value recommendation, and Polycom is a Motley Fool Rule Breakers recommendation. The Fool's disclosure policy wants you to hit it with your best shot. So ... fire away.